July Rates Update

Monthly Commentary

August 14, 2018

After spending nearly all of June stuck in neutral, 10y Treasury yields managed to push
10bps higher to close July at 2.96%, supported by stronger U.S. growth. Despite this sell off
in 10y Treasury yields, the yield curve was still flatter overall on the month with the spread
between 2y and 10y Treasuries falling 5bps to 28bps. Similarly, U.S. equities continued
to grind higher alongside the U.S. dollar, with the latter continuing to exert downward
pressure on the EM risk complex.

Chinese Credit Growth

As U.S. risk assets ground higher in July, their Chinese counterparts continued to struggle
to find traction amid a sharp slowdown in credit growth and burgeoning U.S. – China trade
tensions. While the S&P 500 pushed almost 4% higher in July the Shanghai Composite
fell 6% and is now 18% lower for 2018. Interestingly, this has not come amid a growth
shock in China as real GDP growth of 6.8% YoY in H1 was comfortably above the state
target of 6.5%. Additionally, state GDP is highly scrutinized by the Chinese authorities so
above-target growth may not necessary tell the whole story. It may be that recent efforts to
slow down credit growth were too successful and are starting to manifest in the real and
financial economy. A recent study by Goldman Sachs estimated credit growth in China has
decelerated to 11.2% YoY, the biggest drop recorded. In order to combat this slowdown,
the PBoC has eased monetary policy both by reducing the 7-day repo rate and by cutting
reserve requirements. The authorities have also eased fiscal policy via a loosening of budget
constraints for local governments.

Likely the most important piece of the China economic
puzzle for market participants, the CNY has been allowed
to depreciate 8% on a trade weighted basis since June. This
8% drop has largely offset the 10% tariffs planned by the U.S.
administration, potentially prompting the U.S. government’s
recent announcement that it would consider raising tariffs to 25%
on $200 billion worth of Chinese exports. If Chinese authorities
stand firm and allow for another 15% devaluation against the USD
to adjust for the additional tariffs we would likely start to see U.S.
inflation readings fall along with commodity prices as rapid U.S.
dollar appreciation feeds through into the U.S. economy. Further
impacts of CNY devaluation will potentially be seen in other Asian
exporter countries like Korea and Japan that will be forced to adjust
to a more competitive CNY. This kind of exogenous shock to price
levels has given the FOMC cause for pause under past leadership,
but it remains to be seen how Chairman Powell will handle any
unwanted USD strength.

U.S. real GDP grew 4.1%, annualized, in Q2, its best performance
since 2014. As expected, trade contributed noticeably, boosting
the headline GDP growth rate by 1.1 percentage points. Exports
jumped more than 9% ahead of the implementation of tariffs in
early July. Overall, growth was healthy, led by strong consumer
outlays of +4.0% annualized, solid business spending, including
expenditures on equipment, and a third strong gain in government
purchases. The most notable area of weakness was housing, which
posted a second small quarterly decline in Q2. On balance, there
was nothing in the report that suggests the FOMC will be forced to
forgo a rate hike at the September meeting.

While U.S. growth continues on stable footing, the Bank of Japan
made some adjustments to its own pro-growth policies at the
July policy meeting. Though there were no changes to the policy
rate, the BoJ introduced forward guidance under which it will
maintain current ultra-low interest rate levels until the effects of
the consumption tax hike planned for October 2019 have passed.
With regard to long-term bond purchase operations, the BOJ said
it would take a flexible approach, and at the post-meeting press
conference Governor Haruhiko Kuroda indicated that the bank
would tolerate a wider level of fluctuation in the 10-year JGB yield,
of around 20bp from its 0% target, versus around 10bp at present.
This change in BoJ policy could have major implications for global
yield levels as a major force that has held 10y JGB yields near
10bps has now abated. Now that the Japanese long end is free to
explore slightly higher yields we could see U.S., UK, and German
yields venture higher in sympathy as a key source of demand for
duration moves toward the background.

July also saw policy action from the Bank of England in the form
of a 25bp rate hike that lifted the policy rate to 0.75%. The rate
hike was accompanied by modest upward revisions to growth
and inflation forecasts for 2018 and 2019 as fiscal headwinds are
expected to slowly recede. The BoE made it clear that this was not
the start of any true hiking cycle, just another one-off adjustment
to the policy rate. If the economy continues on the path set up
by BoE forecasts, it appears the next hike is likely at least 6-12
months away. Furthermore, until the full plan and impact of Brexit
is known, it will be difficult for the BoE to provide reliable forecasts.

With only August standing between markets and the fourth quarter
of the financial year, the period of relative calm that accompanies
summer months is almost unanimously expected to subside
and give way to significantly more volatile market conditions.
Potential flare points range from U.S.-China trade conflicts to
ECB tightening attempts to errant tweets but cross-asset volatility
remains unimpressed as both equity and Treasury volatility remain
stuck to the floor. With plenty of catalysts on the calendar for the
fourth quarter there should be sufficient opportunities for asset
volatility to rise little by little or all at once.